RDP 9407: Explaining Import Price Inflation: A Recent History of Second Stage Pass-through 2. Recent Trends in Import Prices

Popular expectations had been that the substantial currency depreciation of the early 1990s would be translated into higher retail prices of imports and, thereby, higher inflation in the short term.^[3] This expectation was influenced by past experience, in particular that of the mid-1980s depreciation (Stevens 1992). Inflationary pressure from higher import prices also seemed probable, if not inevitable, given the evidence that first stage pass-through is completed quite rapidly.^[4]

First stage pass-through is illustrated informally in the first panel of Figure 1, which shows annual changes in the trade-weighted exchange rate (expressed in Australian dollars per unit of foreign currency) and an over-the-docks price for consumption imports (which is measured “free on board”).^[5] Clearly, movements in the exchange rate and free-on-board import prices are nearly identical.

However, second stage pass-through appears much less complete, or at least much slower. From the next panel of the figure, it can be seen that movements in the retail price of consumption imports are less than those for the free-on-board price.^[6]

In particular, decreases in free-on-board prices do not necessarily lead to lower retail import prices.

Finally, the third panel of Figure 1 depicts combined pass-through. By dint of the price adjustment at the second stage, the correlation between changes in the retail price of imports and the exchange rate is quite weak.

Clearly, the transmission of exchange rate changes to final prices has been diffused. Consequently, an important aim of this paper is to quantify differences in the nature of pass-through at the first and second stage. We do this by extending the work of Dwyer et al. (1993). The conceptual framework for our analysis is outlined below.

Footnotes

In the long run, however, it is generally accepted that inflation is governed by the stance of monetary policy. [3]

For example, Dwyer et al. (1993) found that within one year, an exchange rate change was almost fully reflected in the price of imports over the docks. In fact, the bulk of the price adjustment occurred within two quarters. [4]

The exchange rate is the Reserve Bank's trade weighted index (TWI) inverted so that a rise in the index represents depreciation. The free-on-board price is the consumption goods component of the Australian Bureau of Statistic's import price index. [5]

The retail price of imports is represented by “items wholly or predominantly imported” in the regimen of the consumer price index. [6]